MF Global Bankruptcy: Why are clients not protected?

MF Global has declared bankruptcy and its appears that the clients of MF Global will lose a significant the portion of the value of their accounts. The first reaction that most people have is: “How is that possible?” The second question is: and then the next question is: “Could the same happen to my brokerage account?”

The assets in your stock or bond brokerage account are insured up to certain limits ($500K maximum, $250K of which can be cash) by SIPC insurance.

Many brokerage firms offer additional insurance on top of SIPC protection protecting even larger account sizes. The SIPC and private insurance protects client funds in the case where the firm goes bankrupt and/or client funds are missing due to fraud by the firm.

Unfortunately for client’s of MF Global, money held in accounts for trading in the futures and foreign exchange markets do not have the same coverage.

How its Supposed to Work

Futures Accounts

Money held in accounts for trading futures are required by the Commodity Futures Trading Commission (CFTC), to be segregated from the firm’s day to day operating funds. There are 3 primary reasons for this:

Keeping the funds segregated prevents the firm from using client funds for anything outside of transacting on behalf of the client.

In the case where the firm goes bankrupt, its very clear which money belongs to client’s so it can be returned in an orderly fashion.

Also in the case of bankruptcy, client funds are protected from creditors to the firm.

Forex Accounts

Like money held in accounts for trading futures, money held in accounts for trading the over the counter foreign exchange market is not insured against loss. Unlike futures accounts however, money held in accounts for trading foreign exchange does not benefit from segregated funds protection either.

Client funds held in foreign exchange trading accounts can be mixed with the firms operating funds, and in the case of bankruptcy, are not protected from creditors.

What Happened at MF Global

As much of the money held at MF Global was for trading futures, that money should have been segregated by law. As the firm moved towards bankruptcy however, it was discovered that as much as $1.2 Billion in customer money was missing from the segregated funds account. This means that unless this money is recovered and identified as money that should have been held in the segregated funds account, client’s will loose at least part of the money that they have deposited in their accounts.

Where did the money go?

When the former CEO of MF Global was asked after the firm went bankrupt what happened to the missing client funds, his answer was “I simply don’t know where the money is.” As there is such a large amount of money missing however (as much as $1.2 Billion by many estimates) it is unlikely that someone walked off with it in large duffel bags.

In addition to offering their client’s the ability to trade futures and other markets, MF Global also used firm capital to trade on behalf of the firm as well.

In the time leading up to the firm’s bankruptcy they had placed large trades in the debt of European nations (mostly Spain and Italy). They did so with a high amount of leverage, which means they only put up a portion of the total amount of the trade of their own money. This magnifies both the profit and loss potential of a trade.

As the trades the firm made began to move move against them and losses accumulated as a result, they were required to put up more and more money in order to keep the trades open. The firm eventually went bankrupt because it ran out of money needed to keep the positions open.

With this in mind, although it is still not clear where the client’ funds went, it is likely that it was intentionally moved out of the segregated funds account to keep the positions open when the firm ran out of its own money. The intention was likely to use client funds to keep the positions open until they returned to profitability, and then move the money back into the segregated funds account before anyone noticed.